Sri Lanka’s Cautionary Tale: Death by National Debt

The nation of Sri Lanka was many things. A beautiful country, international tourism was a major industry. A fertile land, it grew enough rice to feed all its people. Prosperous, it earned its place as an upper-middle income nation. Then it all went to hell.

Steve Hanke provides an executive summary:

Sri Lanka, an island nation of 22 million people, is in the grips of an economic meltdown. This slow-motion train wreck first began in November 2019 when Gotabaya Rajapaksa won a decisive victory in the country’s presidential elections. He immediately placed family members into key government positions and suspended Parliament. Then in August 2020, his Sri Lanka Podujana Peramuna party — the Sri Lanka People’s Front — posted a landslide victory. The win gave Rajapaksa the ability to amend the country’s constitution, which he quickly availed himself of. In total control, President Rajapaksa and his brother Mahinda, the prime minister, went on a spending spree that was financed in part by Sri Lanka’s central bank. The results have been economic devastation.

But it is the details that are damning.

A Story of Political Greed

National Review‘s Dominic Pino lists the line items that started the ball rolling on blowing out the government’s budget:

The government embarked on a number of wasteful megaprojects. A Times of India report on those projects includes an international airport, a seaport, numerous unnecessary roads and bridges, and a cricket stadium that “has had only a few international matches and is so remote that arriving teams face the risk of wildlife attacks.” Many of these projects were named after the Rajapaksas, an association that would come back to bite them.

You’ve likely heard your community’s elected officials brag about their version of these big, bold initiatives. All promising they will boost the economy and create hundreds or thousands of jobs. But because these are little more than political vanity projects, they can never deliver on that promise.

What they do deliver on is doing whatever it takes to hold onto power. In 2019, Gotabaya Rajapaksa acted to slash taxes while ramping up spending in a bid to gain greater control over Sri Lanka’s government in its next elections. He was successful in achieving his political goal, but to say that wasn’t a smart thing to do is an understatement.

A Bad Combination

Politicians set on increasing spending without having the tax revenues to cover the cost get the money they want by borrowing it. Sri Lanka’s national debt ballooned as it increasingly borrowed from foreign lenders to fund Rajapaksa’s spending. But in 2020, the coronavirus pandemic devastated the country’s economy, especially its large tourism industry, a major source of foreign currency. Without that foreign currency coming in, Sri Lanka’s government was soon starved of the money it was counting on to pay its loans.

Rajapaksa’s response to that shortage of cash drove the next stage of Sri Lanka’s economic collapse.

The Price of Excessive Borrowing

As with people who depend on borrowing to support their lifestyles, the first bills indebted governments pay are those owed to their creditors. Under Rajapaksa, Sri Lanka’s government had to come up with cash to keep their debt-fueled ride going. They got it in April 2021 by terminating the government’s purchases of imported fertilizer. They sold that scheme to Sri Lankans by telling them they were committing to adopt 100% organic agriculture.

Foreign Policy‘s Ted Nordhaus’ sets the stage for what happened next:

Then, just a few months after Rajapaksa’s election, COVID-19 arrived. The pandemic devastated the Sri Lankan tourist sector, which accounted for almost half of the nation’s foreign exchange in 2019. By the early months of 2021, the government’s budget and currency were in crisis, the lack of tourist dollars so depleting foreign reserves that Sri Lanka was unable to pay its debts to Chinese creditors following a binge of infrastructure development over the previous decade.

Having become so indebted, Sri Lanka’s leaders became desperate. They needed cash and that now meant having to take it away from somewhere else. What could possibly go wrong?

A Desperate and Crazy Scheme

Their choice of how they would get the money they needed to keep their debt-funded party going was as desperate as it was crazy.

Enter Rajapaksa’s organic pledge. From the early days of the Green Revolution in the 1960s, Sri Lanka has subsidized farmers to use synthetic fertilizer. The results in Sri Lanka, as across much of South Asia, were startling: Yields for rice and other crops more than doubled. Struck by severe food shortages as recently as the 1970s, the country became food secure while exports of tea and rubber became critical sources of exports and foreign reserves. Rising agricultural productivity allowed widespread urbanization, and much of the nation’s labor force moved into the formal wage economy, culminating in Sri Lanka’s achievement of official upper-middle-income status in 2020.

By 2020, the total cost of fertilizer imports and subsidies was close to $500 million each year. With fertilizer prices rising, the tab was likely to increase further in 2021. Banning synthetic fertilizers seemingly allowed Rajapaksa to kill two birds with one stone: improving the nation’s foreign exchange situation while also cutting a massive expenditure on subsidies from the pandemic-hit public budget.

It went horribly wrong. Because organic farming is much less productive than modern agricultural practices, crop yields plunged. Sri Lankans went from self-sufficiency in producing food to starving in a matter of months. The country’s cash burn worsened, because now it had to import food from foreign sources.

Complete Collapse

A matter of months was all it took for Sri Lanka’s organic farming fiasco to become evident. Rajapaksa responded to that crisis by diverting funds from other things Sri Lanka imports, such as diesel fuel. But those new fiscal diversions have only hastened Sri Lanka’s decline. On May 20, 2022, whatever cash Sri Lanka’s government had access to finally ran out. Sri Lanka’s government defaulted on its national debt for the first time in its history.

The country’s new prime minister, Ranil Wickremesinghe acknowledges the country’s dismal economic situation:

Sri Lanka’s debt-laden economy has “collapsed” after months of shortages of food, fuel and electricity, the prime minister told lawmakers in comments that underscored the country’s dire situation as it seeks help from international lenders.

Ranil Wickremesinghe told parliament the South Asian nation faces “a far more serious situation” than the shortages alone, and he warned of “a possible fall to rock bottom.”

“Our economy has completely collapsed,” he said on Wednesday.

That would be Wednesday, June 23, 2022, just over a month after the government defaulted on its national debt. It didn’t take long to find out how much ruin there was in Sri Lanka.